Johnson Controls Capital Investments

Johnson Controls

Emerging markets are riskier than established ones, and because of that Johnson Controls should make some adjustments to the method by which it evaluates capital investments when dealing in emerging markets. The 2013 Outlook and Strategic Review does not explain how risk is evaluated at Johnson, but the company would normally subject its capital investments to analysis that includes sensitivity analysis, and NPV with sensitivity analysis.

For emerging markets, the hurdle rate would be higher in order to account for the higher degree of risk. China represents over 50% of Johnson's business in Asia, so the company has a significant amount of knowledge about the risk conditions in the Chinese market. Thus, the company can set a hurdle rate that is appropriate to the Chinese market using available information. The company can also estimate the growth rate of China for the coming years, and the risk of inflation. Essentially, taking the same macroeconomic and market indicators that the company would use to analyze domestic risk, and applying it to the emerging market, is the most appropriate way to evaluate emerging market risk.

With better methods for evaluating risk that are more appropriate to emerging market conditions, risk will be reduced. The reason for this is that with better information, the company will be able to understand only projects that fit within its risk preferences. For example, with a higher hurdle rate to accurately reflect risk of any given project specifically, the company will not undertake some projects that it might otherwise have undertaken, had it used its ordinary domestic hurdle rate. By reducing the number of risky projects that the company takes in emerging markets, the company will reduce its overall risk as well.

In addition, the use of sensitivity analysis will help Johnson Controls to improve its decision-making, by providing better information about how changes to different key input variables will affect the overall evaluation of a given project. This technique should be used for all projects, but especially in emerging markets were volatility in some variables -- especially economic ones -- can be significant. By determining how robust a project is in the face of dramatic changes to key variables, the company will make better decisions, based on better information.

2. China has generally been in a state of inflationary pressure for several years, and Johnson Controls knows this. The company will have built the current inflation expectations for China into its forecasts. However, the actual rate of inflation is sometimes different from the expected rate, something that happened with Chinese inflation earlier this year (Bloomberg, 2013). Usually, however, inflation in China is quite predictable (Zhang & Clovis, 2010), since the number from the central government is a work of fiction anyway.

When inflation increases beyond expectations, the present value of future cash flows declines. This is because those future cash flows are worth less in today's dollars, that value diminished by the higher rate of inflation. The ramification therefore is that some projects that might have had a positive net present value prior to the change in inflation could now have a negative net present value. Future cash flows always change when macroeconomic conditions change, especially inflation, because these changes will affect the present value of said future cash flows.

Known inflation projections should always be used when planning capital investments, as well as reasonable estimates for changes in inflation in the future. For example, China's currency is artificially undervalued, which is why the yuan has been on a long-run inflationary trend. One or two shocks in the future should be built into projections. If management is not making decisions about capital investments building in known projections for inflation, then management should be. However, there should also be a sensitivity analysis conducted on these projections, to test the viability of the project given a number of inflation scenarios -- expected case, worst case and best case. The range for inflation figures that can be tested would be developed using historical standard deviations.

3. As noted above, projects in emerging markets are riskier than projects in the developed world. As such, they should have higher hurdle rates. At Johnson Controls, expansion overseas is typically focused on countries it knows well. Thus, the company has the information it needs to set appropriate hurdle rates, especially for a major overseas market like China. The company would simply go through the process of evaluating the different risk factors -- political, economic, currency, etc. -- and use that to help make adjustments to the baseline cost of capital. That cost of capital baseline should be related to the source of financing. If capital from the U.S. is being used to fuel this expansion, the process of determining a hurdle rate would start with the U.S. cost of capital, with adjustments made to reflect the differences between Chinese risk factors and American ones. The reinvestment rate used in the projections would be the Chinese hurdle rate. If the project is being financed with capital already in China, the starting point would be the Chinese hurdle rate, which would already include many risk factors, especially economic factors that would already be built into the costs of financing projects in China.

By making modifications to the hurdle rate to accommodate different risk conditions in major markets around the world, Johnson Controls will arrive at better figures. The company will be able to be more selective with respect to the projects it undertakes, and will be able to only take emerging market projects that do not undermine the company's risk position. These tactics are not likely to give the company competitive advantage because that implies that their competitors are not using these techniques. The reality is that their competitors are also going to be using these techniques to enhance their decision-making in emerging markets. Johnson would have a competitive advantage over any competitor not using these techniques, but against a competitor with equal knowledge of differential emerging market risk conditions, Johnson would only be maintaining equal footing. Nevertheless, it is highly desirable for Johnson to account for differences in the risk conditions by using different hurdle rates and subjecting its projections to sensitivity analysis.

4. Sensitivity analysis is an essential component of capital investment planning for all companies. Johnson Controls should use it extensively in order to evaluate its different proposals. Sensitivity analysis tests the results of the company's evaluation models against changes in specific variables. Thus, if Johnson wants to invest $100 million in a plant in Tianjin, it can test the value of future cash flows under a number of different scenarios for inflation rates, demand conditions, exchange rates, and even tax scenarios. This information will help Johnson to see how well its positive NPV holds up under these different scenarios. A project that does not hold up well to changes in critical or volatile variables -- the inflation rate is a good one -- is a project that Johnson might ultimately decide to reject ever after a positive result in the initial financial analysis.